FIFO Rule in Demat account: Its advantages & disadvantages to investor

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During our conversation with clients, we were surprised to learn that most of them had no clue about FIFO (First In First Out) rule which is applicable on all demat accounts as per IT Ruling Section 25(2A). If you are looking for selling some portion of your shares (lets say 100 out of 200 shares) then FIFO rule can impact your average purchase price for remaining shares. Let’s try to understand where it applies and how it can be used to our advantage as well.

What is FIFO? It’s acronym for “First In First Out” which means all shares will be sold in order of their purchase date. So whenever you sell some shares in a stock, the oldest shares will be sold first. This is applicable on all dematerialized shares. Earlier, when people used to have paper based shares, it was up to the seller to decide which particular share paper he chooses to sell. Buying price determined as per price written on that paper and accordingly taxes were calculated. This helped people to mix loss making shares with profit shares in a financial year to reduce their tax liability. This liberty is only available in case of paper based shares. Since most of us now use dematerialized shares so let’s focus back on how it operates for us.

FIFO in action: Suppose, you purchased 100 shares of HDFC Bank back in 2015. In 2016, you purchased additional 100. Now in 2017, you want to sell 120 shares out of 200 shares. In this case, your demat account will first sell 100 shares purchased in 2015 followed by 20 out of 100 shares purchased in 2016. You can not change this order and it is fixed by demat service providers.

It’s disadvantage: FIFO can impact your average price per share for remaining shares if you plan to sell some portion of your shares at the time when share prices have moved down after your last purchase. Below table explains this phenomenon. FIFO 1.png

In the above hypothetical case, the person decides to sell 12 shares at Rs 150, thinking his average buying price remains Rs 133, so his remaining 3 shares will still remain in profit. This did not happen and post transaction, his average price went up to Rs 200 and all of his remaining shares are in loss. This happened because of the FIFO rule where all his 10 shares are sold first before dipping into remaining 5 shares. So his only shares left were the ones which he purchased at Rs 200. A profitable investment turned into loss making one.

Using FIFO to your advantage: You can use FIFO to your advantage in case of averaging down a stock. A word of caution, averaging down is a tricky strategy since it exposes you more into a loss making stock, so it should be used with extreme care and only on high conviction stocks.FIFO 2

In another example, you average down a high conviction stock and purchased more share at Rs 100 and reduced your average price to Rs 133 from earlier Rs 200. Now if share price comes back to Rs 150, you can sell overpriced shares (since they were purchased first) and with help of FIFO your average purchase price falls ever more to Rs 100, from -25% to +50%. Not bad.

To conclude, FIFO applies only in partial selling of shares and depending upon the conditions as explained above, it may or may not work in your favor. It is purely a mathematical mumbo jumbo and your net returns on overall investment remains the same (i.e Realized profit/loss from selling plus unrealized profit/loss from remaining shares). Having said that, it can still be used for smartly averaging down a stock and get good returns over long term. Moreover as ace investors, you should be mindful of FIFO rules next time you plan for a partial sell.